China’s pollution crackdown shakes up iron ore traders

The ability of policymakers in Beijing to influence global commodity prices has been underlined by recent movements in iron ore prices that has favoured higher quality grades of the steelmaking ingredient.

Over the summer, price differentials between high and low grade iron ore have intensified amid a government-led crackdown on pollution and outdated steelmaking capacity. That has caught many traders on the hop and left some nursing nasty losses from inventory they are struggling to sell.

As China’s steel mills seek higher grade material for use in their furnaces, a tonne of top tier ore with 65 per cent iron content has traded as high as $100 a tonne. To put that figure in perspective, 62 per cent iron ore fines — the industry benchmark — currently transacts for $68 while 58 per cent ore, a lower grade, is at $51.

All of that is a boon for suppliers of high grade material such as BHP Billiton, Rio Tinto and Vale, while a problem for producers at the other end of the spectrum, in particular Fortescue Metals Group. While shares in BHP and Rio are up 1 and 11 per cent respectively this year, FMG is down 10.5 per cent.

Several factors have spurred the blowout in prices between different ore grades, but the underlying driver is “tightness in China’s steel market and a focus on maximising productivity while high margins prevail”, says Alex Griffiths, senior research analyst at Wood Mackenzie, a consultancy.

Around a year ago, China started cracking down on outdated steel production as part of an effort to cut excess capacity, tackle pollution and improve safety. This focused on induction furnaces, which account for 30m to 50m tonnes, or 4-7 per cent of annual Chinese steel production.

The blitz on induction furnaces — typically small, illegal operations that are not captured in official production statistics — had a number of effects but most importantly it helped tighten the steel market in China. This pushed up margins for remaining producers who were quick to exploit the pick-up in prices by running as hard as they could.

“When profitability is really good, the marginal benefit from producing an additional tonne of steel is bigger,” says Macquarie analyst Serafino Capoferri. “So mills try to push as hard as they can on productivity.”

One way to improve operational efficiency involves putting high grade ore fines into blast furnaces. This material produces more steel for each tonne that is used and can also reduce emissions.

Mills in China have also been using larger volumes of lump, a coarser type of iron ore that can be fed directly into furnaces. This removes the need for sintering, the most polluting stage of the steelmaking process. (Sintering turns smaller iron ore particles such as fines into a lump).

In fact, panic buying by Chinese mills in the wake of local government-led crackdown on sintering activity has seen lump recently trade at a record premium of more than $30 a tonne to the benchmark fines price.

Demand for high grade products has also been stoked by the looming production cuts. In an effort to reduce smog, heavy industry in cities around Beijing will have to slash production during the winter heating season from October to March. That has sparked some front loading of steel production say analysts.

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FMG and other producers reckon the spread between high and low grade iron ore will narrow as margins in the China’s steel industry — which have been boosted by a crackdown on low-tech capacity — revert to more normal levels.

That view is challenged by Rio and others who say the price gap between high and low grade ore could persist if China continues with its supply-side reforms and efforts to clean up the environment.

“There is no doubt in my mind that China will restructure its steel industry . . . and the only way for them to do it is by improving the quality of their input material,” Rio chief executive Jean-Sébastien Jacques told the Financial Times last month. “I would not be surprised if the gap between high and low grade ore is a structural shift.”

Richard Knights, analyst at Liberum Securities, says the only way Chinese steel prices can be maintained is if there is another significant reduction in capacity, noting that with credit and fixed asset investment turning down, the property market in big cities is slowing.

Concerns about slowing Chinese demand is already starting to weigh on benchmark iron ore prices, they have already started to roll over, falling $10 in the past month to $68.

“We are looking at price of $65 for the fourth quarter,” says Mr Capoferri. “But we are lot more bearish about 2018 due to our view on housing in China.”